In the third quarter of 2018, global equity markets’ performance was mostly positive with developed markets outperforming emerging markets for the second straight quarter: 1.35% versus -1.09% as measured by MSCI EAFE Index and MSCI Emerging Markets Index, respectively. As with the previous quarter, global economic data including employment, manufacturing and investment pace of growth indicated economic expansion. However, geopolitical risks, potential trade wars and U.S. dollar strength weighed on returns.

European economic growth remained robust with second quarter GDP growth of 2.1%. PMI data released during the quarter signaled continued economic growth led by a strong service sector. The trajectory of the economic expansion has not been the same across all regions. Italy and Spain saw their expansion weaken during the quarter. Furthermore, ongoing tariff negotiations continued to cast a shadow over future growth with business optimism across the eurozone falling to a near two-year low. Political uncertainty also hurt optimism. In Germany, Chancellor Merkel struggled with a weakened coalition following disagreements over immigration policy, while in the Republic of Turkey President Erdogan struggled with a high level of U.S. dollar-denominated debt, stifling inflation, double-digit interest rates and a battered lira. In Italy, asset prices fell and yield spreads widened following the government’s release of its draft budget that proposed a deficit of 2.4%, well above the European Commission’s target of 1.6%. Finally, in the U.K., despite months of negotiations, Brexit remained unresolved. The uncertainty surrounding Brexit helped contribute to the first drop in export orders since 2016.

China’s economy showed further signs of cooling during the quarter. Chinese officials signaled their desire to support their economy leading to additional stimulus–including an easing of credit controls and increased spending on public projects. While nowhere near the level of past stimulus plans, officials from the NDRC (National Development and Reform Commission) expressed their confidence in hitting 6.5% GDP growth for the year. The ongoing trade spat with the U.S. also led Chinese officials to support the renminbi. While the impact from import tariffs was relatively subdued for Japan, the government downgraded its export outlook for the first time in three years and business sentiment remained muted. However, Japan’s domestic economy remained strong. A tight labor market led to a 3% increase in the minimum wage for the third straight year while capital spending plans rose to a 38-year high. Manufacturing activity was negatively impacted from July’s weather-related flooding but is expected to recover. At the end of the quarter, bilateral trade talks between the U.S. and Japan were expected in short order. In early 2019, the two countries will enter negotiations toward a “United States-Japan Trade Agreement” under which tariffs on imported goods will be reduced or removed.

The U.S. economy continued to expand with second quarter GDP growth accelerating to 4.2%, close to a four-year high. Underlying the current strength is increasing capex spending and domestic consumption. At its September meeting, the Federal Reserve responded to recent strength by increasing its benchmark rate by 0.25%. As discussed earlier, trade tensions linger. While deals were reached with Mexico and Canada, deals with Japan, the European Union and China have yet to be reached as of the quarter end.

Performance

Federated International Small-Mid Company Fund (A Shares at NAV) returned 0.83% for the quarter ending September 30, 2018. That compares to its benchmark, the MSCI All Country World ex-U.S. Index, which returned -0.71% during the period.

Performance quoted represents past performance, which is no guarantee of future results. Investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than what is stated. Other share classes may have experienced different returns than the share class presented. To view performance current to the most recent month-end and for after tax returns, click on the Performance tab. Performance does not reflect the maximum 5.5% sales charge for A Shares. If included, it would reduce the performance quoted.

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Performance Contributors

Stock selection in the Health Care and Consumer Discretionary sectors

In Consumer Discretionary, Swiss life sciences company Lonza Group AG was the fund’s top contributor. Chugai Pharmaceutical Co. Ltd. and AstraZeneca also delivered strong performance

Dewan Housing Finance Corporation Ltd. was the fund’s largest single stock detractor

How We Are Positioned

While economic growth remains resilient in the United States, trends have been less robust in the rest of the world. The decoupling of economic fortunes has also spilled into the equity markets, with all major U.S. indices positive this year while most international markets have produced negative returns, especially when measured in U.S. dollars. The good news is that it’s not all doom and gloom in our markets and we see the outlook for risks and opportunities as relatively balanced going forward.

On the positive side, the recent deal between the United States, Canada and Mexico called USMCA (which replaces NAFTA), demonstrates that common ground can be found during these difficult trade negotiations. Focus will now shift to the eurozone as the United Kingdom and European Union near the Brexit deadline. Recent developments indicate progress has been made on the contentious issue of the future Irish border which could soon pave the way for a Brexit deal. The success of USMCA and potentially Brexit is offset by deteriorating relations between the United States and China. Unfortunately, we believe the dispute between the United States and China could persist into next year.

Robust employment is another positive highlight of our key markets. Japan’s 2.4% unemployment rate is at a 24-year low while Germany’s 3.4% rate is at a 38-year low. Low unemployment has supported strong consumption trends and underpins the fund’s overweight positioning to the Consumer Discretionary and Technology sectors.

On the negative side: China, the world’s second largest economy, has been showing signs of weakening as relations with the United States remain strained. The slower trends in China have spread to the manufacturing sectors of Japan and Europe. As a result, the fund has an underweight position in the Industrials sector.

Given the uncertainties stated above, the fund continues to have a balanced mix of defensively and cyclically exposed holdings. The recent volatility has led to more attractive valuations overseas. For example, the S&P 500 trades at twice the multiple of the MSCI World ex-USA Index on a price-to-book multiple and a significant premium on a price-to-earnings multiple. As bottom-up stock pickers, we are beginning to find more opportunities in an effort to take advantage of the recent weakness in our markets.

Key Investment Team

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Mutual funds are subject to risks and fluctuate in value. Click on Performance for fund specific risks.